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COST-VOLUME-PROFIT ANALYSIS
Contribution Margin:
The amount of sales available to cover fixed expenses with any remaining
contribution margin providing profits.
If the contribution margin is not sufficient to cover fixed expenses, there will be a
net loss for the period.
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Target Profit:
Rather than setting operating income = 0, target profit calculations assume a
certain operating income and calculate the sales dollars and units sold necessary
to achieve it.
The same equations are used as to calculate the breakeven point, except that a
non-zero operating income term is included in the numerator.
Margin of Safety:
The margin of safety is the excess of budgeted or actual sales over the breakeven
volume of sales.
It is expressed as both the dollar amount of the difference and as a percent of
budgeted or actual sales.
Sales Mix:
Companies that sell more than one product make the breakeven and target profit
calculations a bit more complex.
Each product has its own breakeven equation and sales volume, none of which
represents the breakeven equation for the entire company. A breakeven equation
can be developed for the whole company by combining the breakeven equations
and sales volumes (the sales mix) for the individual products.
The sales mix is assumed to remain constant to simplify the calculations.
Changes in sales volume are assumed to be in the constant sales mix.
Operating Leverage:
Operating leverage quantifies, at a given level of sales, the percent change in
operating income caused by a percent change in sales.
Leverage calculations are a two-step process:
o First, calculate the Degree of Leverage or Leverage Factor
Contribution Margin
Degree of Leverage =
Operating Income
o Second, calculate the percent change in operating income:
Percent change in Degree of Leverage x Operating Income
=
operating income
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Breakeven Equations
The breakeven point is expressed in sales dollars and units sold. The link
between the two is selling price per unit, meaning that breakeven units sold x
selling price per unit = breakeven sales.
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Example #1
W Company sells only one product with a selling price of $200 and a variable cost of $80
per unit. The company’s monthly fixed expense is $60,000.
Required: Determine the breakeven point in units sold and sales dollars.
Solution #1
Target Profit
The same equations are used as to calculate the breakeven point, except that the
target profit is included in the numerator.
An alternative solution starting from the breakeven point is also possible.
Example #2
L Company sells only one product with a selling price of $200 and a variable cost of $80
per unit. The company’s monthly fixed expense is $60,000. The corporation would like
to achieve a profit of $30,000 next year.
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Solution #2
Alternate Solution:
Additional units Target profit $30,000
Contribution margin $ $120 250 units
per unit
Example #3
S Company sells pillows for $90 per unit. The variable expenses are $63 per pillow and
the fixed costs are $135,000 per month. The company sells 8,000 pillows per month.
The sales manager is recommending a 10% reduction in selling price, which he believes
will produce a 25% increase in the number of pillows, sold each month.
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Solution #3
Present Proposed
Per Unit % Total Per Unit % Total
Units 1 8,000 1 10,000
Sales $90 100.0 $720,000 $81 100.0 $810,000
Variable expenses 63 70.0 504,000 63 77.8 630,000
Contribution Margin 27 30.0 216,000 18 22.2 180,000
Fixed expenses 135,000 135,000
Operating income $81,000 $45,000
8000 Pillows X 1.25 = 10,000 pillows; $90 per pillow X .9 = $81 per pillow
Since the operating income decreased by $36,000, from $81,000 to $45,000, the sales
manager’s suggestion should not be implemented.
Margin of Safety
Example #4
Using the data in Example #3, determine the margin of safety under current operating
conditions.
Solution #4
Present Breakeven
Per Unit % Total Total
Units 1 8,000 5,000 $450,000/$90
Sales $90 100.0 $720,000 $450,000 $135,000/30%
Variable expenses 63 70.0 504,000 315,000 $450,000x70%
Contribution Margin 27 30.0 216,000 135,000 fixed + OI
Fixed expenses 135,000 135,000 stays the same
Operating income $81,000 $0 Always $0
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Sales Mix
Example #5
Z Company sells two models of doghouses, the Puppy Palace and the Canine Castle.
Puppy Canine
Palace Castle
Sales price per unit $50 $75
Variable cost per unit 30 50
Contribution margin per unit $20 $25
Z Company has determined that it would break even at an annual sales volume of
50,000 units, of which 75% would be Puppy Palaces.
Required: a) What are the contribution margin ratios for each product and the
company?
b) What is the amount of Sanchez's estimated annual fixed costs?
c) What is the sales mix?
d) Prepare a product line income statement with operating income of
$400,000. Fixed production costs will increase $45,000 and fixed
administrative costs will increase $22,500 to support the increase
in volume.
Solution #5
a)
Puppy Canine Sanchez
Palace Castle Company
Volume 50,000 50,000
75% 25%
37,500 12,500
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b)
Puppy Canine Sanchez
Palace Castle Company
Sales $1,875,000 $937,500 $2,812,500
Variable cost 1,125,000 625,00050 1,750,000
Contribution margin $750,000 $312,500 $1,062,500
Fixed costs 1,062,500
Operating Income $0
c) The sales mix can be expressed as 3:1 based on the ratio of 37,500 units : 12,500
units. This means that when sales volume increases, it will be in groups of four
units (3 puppy palaces and one canine castle). Each group will have a sales value
of $225 = 3 x $50 + 1 x $75 and a contribution margin of $85 = 3 x $20 + 1 x
$25.
d)
Puppy Canine Sanchez
Palace Castle Company
Volume in groups of 4 units 18,000 18,000
Sales mix 3 1
Product units 54,000 18,000
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Operating Leverage
Example #6
P Company sells pillows for $90 per unit. The variable expenses are $63 per pillow and
the fixed costs are $135,000 per month. The company sells 8,000 pillows per month.
Solution #6
Present Proposed
Per Unit % Total Total
Units 1 8,000 8,800
Sales $90 100.0 $720,000 $792,000
Variable expenses 63 70.0 504,000 554,400
Contribution Margin 27 30.0 216,000 237,600
Fixed expenses 135,000 135,000
Operating income $81,000 $102,600
The proportion of variable to fixed costs will have a significant effect on operating
income as the level of sales changes:
o A higher proportion of fixed costs means a lower proportion of variable
costs and a higher contribution margin ratio and contribution margin per
unit.
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Now consider how changes in the sales level affect operating income:
Company A had higher variable costs and lower fixed costs, a lower CM
ratio and lower income volatility when units sold changed: income increased
$150 ($100 to $250) or decreased $60 ($100 to $40).
Company B had lower variable costs and higher fixed costs, a higher CM
ratio and higher income volatility when units sold changed: income
increased $350 ($100 to $450) or decreased $140 ($100 to a loss of $40).
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Practice Problems
Practice Problem # 1
M Company produces only one product, organic fruit baskets, which it sells for $90 each.
Unit variable costs are $63 and total fixed expenses are $21,000. Actual sales for the
month of May totaled 2,000 units.
Required: Compute the margin of safety in dollars and percentage for the
company for May.
Practice Problem #2
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Practice Problem #3
The wine director’s salary is $36,000 per year plus tips, which average $160 per month.
Practice Problem #4
I Company reported the following results from its income statement for the year:
Sales of $1,000,000 for 10,000 units sold. Contribution margin ratio was 30% and
operating income was 10% of sales. Units sold are expected to increase 10% next year
and an additional 20% the year thereafter with no changes in fixed expenses.
Practice Problem #5
F Company is debating whether to purchase new equipment that would increase fixed
costs from $96,000 to $196,000, and decrease variable costs from $14 per unit to $8
per unit. If it were to implement the change at its current production level of 100,000,
profit would not change. Selling price is $20 per unit.
Required: a) What would happen to the company's profit if the change were
implemented and production decreased to 15,000?
b) Prepare a breakeven income statement if the new equipment was
purchased
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Practice Problem #6
K Company produces three picnic products: koolers, baskets and grills. A product line
income statement for the year is shown below:
Practice Problem #7
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Practice Problem #8
120
100
80
Dollars
60
40
20
0
0 20 40 60 80 100 120
Units of activity
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3. Target units equals fixed costs plus target profit divided by the unit
contribution margin.
True False
4. The target sales level equals fixed costs plus variable costs divided by the
contribution margin ratio.
True False
5. Margin of safety is the difference between actual sales and budgeted sales.
True False
9. If the unit contribution margin is $1 and unit sales are 15,000 units above the
break-even volume, then net income will be $15,000.
True False
10. A target net income is calculated by taking actual sales minus the margin of
safety.
True False
11. If variable costs per unit are 70% of sales, fixed costs are $290,000 and target
net income is $70,000, required sales are $1,200,000.
True False
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12. Cost-volume-profit analysis assumes that all costs can be accurately described
as either fixed or variable.
True False
13. On a CVP graph, the break-even point is the point at which the contribution
margin line crosses the total cost line.
True False
14. Break-even units can be found by dividing fixed costs by unit contribution
margin.
True False
15. The target sales level equals fixed costs plus variable costs divided by the
contribution margin ratio.
True False
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4. J Company has a selling price of $15, variable costs of $10 per unit, and fixed
costs of $25,000. How many units must be sold to break-even?
a) 5,000
b) 10,000
c) 2,500
d) 1,667
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6. P Company has fixed costs of $200,000, sales price of $50, and variable cost of
$30 per unit. How many units must be sold to earn profit of $50,000?
a) 2,500
b) 10,000
c) 12,500
d) 25,000
7. H Company has sales of $400,000, variable costs of $12 per unit, fixed costs of
$100,000, and a target profit of $60,000. How many units were sold?
a) 10,000
b) 15,000
c) 20,000
d) 25,000
8. B Company has fixed costs of $20,000 and a contribution margin ratio of 40%.
Currently, sales are $75,000. What is Bowl's margin of safety?
a) $20,000
b) $25,000
c) $30,000
d) $50,000
10. If the price is changed, how many units will G Company need to sell for profit
to remain the same as before the price change?
a) 10,000 units
b) 11,250 units
c) 12,000 units
d) 12,500 units
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11. Y Company is debating whether to change its cost structure so that fixed costs
increase from $300,000 to $400,000, but variable costs decrease from $5 per
unit to $4 per unit. If it were to implement the change at its current production
level of 100,000, profit would not change. What would happen to the
company's profit if the change were implemented and production increased to
125,000?
a) It will stay the same.
b) It will increase.
c) It will decrease.
d) It could increase or decrease
14. N Company sells two products. Product A sells for $100 per unit, and has unit
variable costs of $60. Product B sells for $70 per unit, and has unit variable
costs of $50. Currently, N Company sells three units of product B for every one
unit of product A sold. N Company has fixed costs of $750,000. How many
units would N Company have to sell to earn a profit of $250,000?
a) 40,000 units of A and 40,000 units of B
b) 10,000 units of A and 30,000 units of B
c) 30,000 units of A and 10,000 units of B
d) 20,000 units of A and 20,000 units of B
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16. Last month K Company had a $30,000 profit on sales of $250,000. Fixed costs
are $60,000 a month. What sales revenue is needed for Calico to break even?
a) $166,667
b) $90,000
c) $30,000
d) $280,000
17. Last month C Company had a $15,000 loss on sales of $150,000. Fixed costs
are $60,000 a month. How much do sales have to increase for Calico to break
even?
a) $60,000
b) $75,000
c) $45,000
d) $50,000
18. KV Company has fixed costs of $400,000 and a contribution margin ratio of
25%. How much sales revenue must be earned for a profit of $80,000?
a) $80,000
b) $400,000
c) $1,600,000
d) $1,920,000
19. S Company has sales of $105,000, variable costs of $4 per unit, fixed costs of
$25,000, and a profit of $20,000. What are the contribution margin and
contribution margin ratio?
a) $4.00 and 133%
b) $4.00 and 57.1%
c) $3.00 and 42.9%
d) $3.00 and 75%
20. T Company sells two products. Product A sells for $100 per unit, and has unit
variable costs of $60. Product B sells for $70 per unit, and has unit variable
costs of $50. Currently, T Company sells three units of product B for every one
unit of product A sold. Toyoda has fixed costs of $750,000. How many units
would T Company have to sell to earn a profit of $250,000?
a) 40,000 units of A and 40,000 units of B
b) 10,000 units of A and 30,000 units of B
c) 30,000 units of A and 10,000 units of B
d) 20,000 units of A and 20,000 units of B
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Practice Problem #2
a)
Present Breakeven
Units sold 10,000 10,000
Sales $600,000 $636,000
Variable expenses 420,000 420,000
Contribution 180,000 110,000
margin
Fixed expenses 110,000 110,000
Operating income $ 70,000 $0
b)
I. II. III.
Units sold 4,000 3,200 4,200
Sales $264,000 $192,000 $252,000
Variable expenses 168,000 96,000 176,400
Contribution 96,000 96,000 75,600
margin
Fixed expenses 96,000 96,000 75,600
Operating income $0 $0 $0
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Practice Problem #3
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Practice Problem #4
Practice Problem #5
F Company is debating whether to purchase new equipment that would increase fixed
costs from $96,000 to $196,000, and decrease variable costs from $14 per unit to $8
per unit. If it were to implement the change at its current production level of 100,000,
profit would not change. Selling price is $20 per unit.
At 15,000 units produced and sold, the company would have a net loss of $16,000.
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Practice Problem #6
Adding few basic calculations from the problem data (shown in bold) will make solving
the problem much easier.
a) Applying the percentages of total sales and the contribution margin ratios to a
break-even income statement (income = 0):
Koolers Baskets Grills Total
% Total Sales 30% 50% 20%
Sales $187,013 $311,688 $124,676 $623,377
Variable expenses 102,857 218,182 62,338 383,377
CM 84,156 93,506 62,338 240,000
CM Ratio 45% 30% 50% 38.5%
Fixed expenses 240,000
Operating income $0
b) Since grills have been discontinued, the percentages of total sales for the
remaining two products and the overall contribution margin must be recalculated:
Koolers Baskets Grills Total
% Total Sales 37.5% 62.5%
Sales $189,474 $315,789 $505,263
Variable expenses 104,211 221,052 325,263
CM 85,263 94,737 180,000
CM Ratio 45% 30% 35.625%
Fixed expenses 180,000
Operating income $0
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d)
Koolers Baskets Grills Total
% Total Sales % % %
Sales $792,000 $1,320,000 $800,000 $2,912,000
Variable expenses 435,600 924,000 400,000 1,759,600
CM 356,400 396,000 400,000 1,153,400
CM Ratio 45% 30% 50% 39.6%
Fixed expenses 380,000
Operating income $773,400
Practice Problem #7
Per Unit:
Selling price $70 $60
Variable cost 40 40
Contribution margin $30 $20
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1. True
2. True
3. True
4. False - Target sales level equals fixed costs plus target profit
divided by the contribution margin ratio.
5. False - The margin of safety is the difference between actual or
budgeted sales and break-even sales.
6. True
7. True
8. False - The break-even point is calculated for the entire company
using total contribution margin, weighted average
contribution margin ratio and total fixed expenses.
9. True
10. False - Target operating income is target contribution margin –
fixed expenses.
11. True
12. True
13. False - The break-even point is the point at which the total
revenue line crosses the total cost line.
14. True
15. False - Target sales level equals fixed costs plus target profit
divided by the contribution margin ratio.
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